Business Basics – Better Boards Build Better Businesses

Good corporate governance – having an active board of directors – is essential in building a good company. Assembling a capable board should be done sooner than later. Why?

“We must all hang together, or assuredly we shall all hang separately!” (Benjamin Franklin)

The Team

There are many sayings like the one quoted above to remind managers and entrepreneurs that it takes a team to build a successful venture. A company’s board of directors is the ultimate team that accepts the overall responsibility for the firm. Unfortunately, even if you hang together, and something goes wrong, each director may be held singularly accountable both to the shareholders and to the general public.

The Ideal Board

An ideal board is one which works closely with the Chief Executive Officer (the “CEO”) of the company to give not only support and direction to him or her, but one which also challenges the CEO to make sure that s/he leads the company in accordance with the company’s plans. Many boards are “puppet” boards and often play along with the CEO and management. These are useless. The board should be the pillar which holds the company up. The board is responsible for the success or failure of the company. Furthermore, it is the soul and conscience of the enterprise. If management is not doing its job that is because the board is not doing its job in the first instance. The mandate of the CEO, guided by an active board, is to drive the value of the company. A board serves the company – not specific shareholders or groups.

When companies first begin, the shareholders, managers, and board members are all one and the same. For example, if a few people launch a new business, they will all be the initial shareholders, managers, and directors. As they evolve, these three groupings of company participants may diverge with respect to the people involved in each category. The shareholders own the company and they appoint the directors who in turn appoint the managers. When companies raise capital by attracting new investors, these new shareholders will, with the current shareholders, want to make sure that their interests are served by a competant board of directors. Many private companies operate like partnerships, i.e. the people who run the company also own it and govern it without involving any outsiders. On the other hand, there is a trend by shareholders – regardless of number – to attract external, independent people to serve as corporate directors – thereby copntributing expertise and oversight and a “big picture” perspective. In larger, public corporations, the only manager on the board is the company’s CEO. Directors are generally also shareholders in the company – this aligns their interests with other shareholders whom they serve.

Corporate Governance

What is “corporate governance”? In the wake of recent corporate scandals in the U.S., this term is being heard more often. Some people view it as more rules and regulations while others see it as an opportunity to build better businesses.

In searching for various definitions, I came across one offered by the OECD in April 1999 that is generally consistent with many others: “Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.” Increasingly, many of the rules and procedures are being dictated by government regulators (for example, the American’s Sarbanes-Oxley Act passed in the summer of 2002) trying to ensure that, at least in the public markets, the various stakeholders interests are fairly protected.

In these days of excessive litigation, the words corporate governance take on new meaning. In the past, directors may only have paid lip service to the notion of protecting the interests of all shareholders and other stakeholders (i.e. clients, suppliers, governments) but today, they are taking their role far more seriously. Class action lawsuits, which have been very popular in the USA are now becoming more common in Canada. Such class action suits permit aggressive lawyers to sue negligent corporate directors on behalf of a class of litigants, e.g. shareholders.

It is a common misconception that because companies are incorporated they, and persons associated with them, have limited liabilities. Not so. Not only are directors accountable to the company, but they are also the “real people” against which other parties may make claims of a financial, or even criminal, nature. Although corporations generally indemnify their directors against legal actions and often take out directors’ liability insurance as a hedge against such actions, directors may nonetheless not be fully protected. This personal legal exposure or risk is not reduced for directors who may simply be serving as directors on behalf of a shareholder. This situation may arise when, for example, a corporate shareholder (e.g. a parent company or major investor) appoints individuals to serve on the board of an affiliated or subsidiary enterprise. Remember that shareholders have no liability or responsibility other than appointing the directors who then assume all the responsibility.

Good corporate governance begins with a board charter, i.e. a document that spells out, for a particular company, exactly how it is going to be run. It will spell out the board’s responsibilities and mandate so that all parties know what is expected. Such a charter will evolve as a company grows and matures.

The Role of a Director

Typically, a director is (or should be) a shareholder in the company. Directors are appointed, i.e. voted into office, by the shareholders of a company at a properly convened meeting of shareholders. The number of directors of a company is determined by a special resolution of shareholders, which number can be changed only by a shareholder vote (although boards can fill vacancies and make minor changes to board composition). In general, shareholders will appoint themselves as directors (as is the case for small companies) or will vote on a slate of nominees proposed by any shareholder(s). Certain shareholders, by virtue of a shareholders’ agreement or voting trust, may have the right to appoint directors to a board. The directors are accountable to all shareholders and must act in the best interests of the company. Furthermore, directors are not protected by those that appoint them.

Additionally, directors have a legal obligation to ensure that a company is operated in a proper, legal, good-corporate-citizen style. If a company’s products blow up in the face of a consumer, or if a company fails to remit taxes, it is the directors that are held liable and they may be personally sued. For this reason, many companies will subscribe for liability insurance and will also indemnify directors against such actions. But, the directors may still be exposed. In a recent, spectacular, case involving Canadian Airlines, the entire board resigned from office because the airline was on the verge of financial disaster in which case the directors would jointly and severally be responsible for employee wages and taxes owing by the airline!

The time commitment of a directorship should not be underestimated. Even though your board may only sit formally once each quarter, as a director you must know what is going on all the time. You can never use the excuse that you weren’t told about something. You will likely also be asked to serve on board committees (compensation committee, audit committee, executive committee, etc.). A good chief executive will use his board wisely – seeking counsel and advice regularly and will keep his board fully informed on major issues.

In the case of public companies, a reputable board comprised of objective, “outside” directors is seen to be a plus in the eyes of investors. These outside directors, often referred to as the “independent” directors because they are independent of management are supposed to hold management accountable for corporate actions and serve in the best interests of the company. Often, shareholders’ interests are at odds with those of management. For example, paying huge management bonuses or being excessively generous with stock options may be good for managers while reducing shareholder value. Having a slate of independent directors shows that the company has good leadership and at the same time, that these leaders are willing to assume the potential personal liabilities required to make the company successful.

Directors are very powerful. They often do not even understand the extent of this power. A director, dissatisfied about some management action, could call a board meeting to deal with the matter. He or she needn’t wait for the next scheduled meeting. A director may sign important legal documents on behalf of a company making onerous commitments on behalf of that company. Finally, a company’s officers, especially the President and CEO, are appointed by, and accountable to, the directors.

Directing versus Managing

Directing is not the same as managing. Directors make sure that managers are doing the managing and that the company has recruiting the necessary talent for this purpose. Directors hold management accountable. It is a good practice to have directors require that management produce regular updates on progress, especially in the early years. For startups a weekly reporting system is not uncommon. In the case of young companies, directors often become quite involved in day to day matters and sometimes they assume a part-time management role as well. Directors work with management to approve budgets, business plans, senior job descriptions, compensation, policies, and financial statements. With respect to job descriptions, it is advisable to draw up some “terms of reference” for a board which clearly articulate not only legal duties and responsibilities but also any other expectations.

Should I Be a Director?

In situations where you are a substantial shareholder in a company, it makes sense for you to be a director. What is substantial? In a small firm, anything over 10% would certainly be substantial. The owners and founders of a company usually comprise its first board of directors. It would be very unusual for a key person not to be a director.

If asked to be a director of a company, you have to weigh the pros and cons very carefully. You should first ask why you are being nominated. Is it because of your reputation or because of certain skills and contacts you may have? What potential risks and liabilities are you assuming by agreeing to serve on the board? To what extent can the company indemnify its directors against claims? What is your reward for taking such a risk? In this regard, stock option plans, or even better – stock purchase or ownership plans – are very attractive inducements and can be very effective, especially in cases where one has been invited to serve on behalf of other shareholders without necessarily having a personal equity stake. Directors are often paid a fee in addition to any stock appreciation compensation they may have. Some companies pay a fixed amount per board meeting, others pay a monthly or annual retainer. A retainer, regardless of amount, is likely the best because, in principle, directorship is a full-time, 7×24, job.

A potentially problematic situation may occur if you are asked by a shareholder to serve on a board on that shareholder’s behalf. For example, if you are an employee of a shareholder, i.e. a where that shareholder is a corporate body, as may be the case in an investment company (e.g. a Venture Capital investor asks one of its investment managers to serve on an investee’s board), you will be faced with a two-fold responsibility as well as exposing yourself personally, without necessarily being protected by the shareholder on whose behalf you are serving. Although liability insurance may reduce the potential liability, it will not eliminate it.

If you are asked to serve as a director for a company with which you or your employer have some other relationship with that company, e.g. a strategic alliance or vendor/supplier relationship, be extra cautious – you may find yourself in a conflict of interest situation by trying to serve two parties. When you agree to become a director of a company, you may be precluded from having any involvement with other companies due to non-competition or conflict of interest concerns. Because such restrictions may be imposed, not to mention the liability issues, directors must be appropriately compensated. Far too many people think they are doing a favor for a friend or business associate by serving as a director for them without any compensation. That’s bad business – for both parties!

Being asked to serve on a major corporate board such as IBM is a lot different than being asked to serve on the board of Fly-By-Night Enterprises. Many people view serving on high-profile prestigious boards as a valuable asset in their own career development – not to mention the perks they might enjoy (such as free first-class air travel if they are on the board of an airline).

Being a director of a public company is an order of magnitude more onerous than being a director of a private company. In a private company, it is possible to learn about directors’ responsibilities on-the-fly. This is not advisable for directors of public companies. Directors of public companies must familiarize themselves with the very extensive matters of corporate governance relating to the regulatory environment and the applicable securities legislation (e.g. the B.C. Securities Act that regulates all companies). There is so much that must be learned that special educational programs are being offered to executives. Simon Fraser University, for example, in cooperation with the stock exchanges and regulatory bodies, offers a special three-day course on corporate governance. Of particular concern are such activities as insider trading, corporate filings, investor relations and public disclosure issues. It is very easy for a director of a public company to make an innocent mistake through ignorance. You can rest assured – the law courts and the news media won’t look it it in the same way!

Are you a board member or just plain bored? Aside from everything else, being a board member should be fun and interesting. Don’t join a board until you’ve met other board members. Consider a trial period – i.e. date before you marry! Know something about the dynamics of the board first. Does the CEO listen to his board? Some board meetings can become exercises in showmanship or stress control while others are little more than fan clubs.

If you choose to accept a directorship, you will find that there are many resources available to you to help you become an effective director. There used to be no special qualification such as a certificate, diploma or belonging to a professional association in order to be a director. While this is still the case, some regulators do require or suggest that directors meet certain standards. We are likely to see more of this in the public arena. Regardless, there are organizations such as the Institute of Corporate Directors (www.icd.ca) that can provide resources and educational content to enable us to be better directors.

The Corporate Registry

In Canada, companies are either provincially or federally incorporated with provincial incorporations being the most common. Each jurisdiction has a corporate registry office which maintains corporate information on all incorporated companies – public and private. Anyone can access this information, sometimes for a small fee, to determine a company’s status, legal address, as well as the names and addresses of its directors. This is how potential litigants can easily track down the directors. It may not be sufficient for a director to submit his or her resignation to the company. The company, or its legal counsel, must execute the appropriate filing with the Registrar of Companies. I know an ex-director who was once served by the U.S. department of Internal Revenue with a tax claim pertaining to a Canadian company because the corporate filing was neglected! In B.C., the Corporate Registry may be found at http://www.fin.gov.bc.ca/registries/corppg/.

Legal Issues

Directors must meet certain qualifications before they can act as such. For example, directors must be at least 18 years of age. Persons who are undischarged bankrupts or who have been convicted of a criminal act or a securities violation may not be allowed to serve as directors.

Directors owe a fiduciary duty to both the company and all shareholders and as such must act in the interests of all shareholders. A director may be held liable by others if he or she acts in such a manner as to be detrimental to their interests. Great care has to be taken to declare any possible conflicts of interest and to avoid deriving any personal benefits in preference to the company (for example diverting business away from the company).

Directors must act in accordance with any applicable legislation, notably the Company Act and the Securities Act. Other Acts (e.g. Employment Standards, Social Services Tax Act, Worker’s Compensation, etc) pertaining to corporate management may also give rise to personal liability. Not knowing the laws does not absolve a director from any responsibility and liability. Directors may even be liable under the Criminal Code where a company has committed a crime (e.g. fraudulent tax claims, environmental damages, etc).

Companies may endeavor to indemnify directors against any liabilities that may arise. However, it should be noted that Courts will not permit companies to indemnify directors in some matters. Directors likely can not (and should not) be indemnified for their failure to fulfill their duties and obligations to the company. Insurance policies may be taken by a company to assist in effecting indemnification and these policies will usually include exclusions for various breaches of duty.

Resigning a directorship will not remove any liability which occurred while being a director. Directors are still responsible for actions which occurred during their tenure. Anyone contemplating a board position, ought to seek their own legal advice and take certain steps to “bullet-proof” themselves.

If it really is so onerous being a director, are there any liabilities which can be avoided? Yes. One of the most common ones is normal trade credit (and this is one of the main reasons why a proprietorship may choose to become incorporated). If a company has debts outstanding to trade creditors (i.e. suppliers), the directors are not personally liable for those debts. If a creditor takes a company to court, the directors may have to appear in court but a judgment against the company does not have to be made good by directors unless they have given personal guarantees or indemnities to those with whom they are transacting business.

Other Alternatives

Companies and potential directors might consider other, less onerous, forms of relationship. For example, it is fashionable to use “advisors” (this is a euphemism for free consultant). For purposes of gaining knowledgeable advice and instilling investor confidence, this may be adequate. If your name is Werner von Braun and you are a special advisor to Acme Rocketship Corp, this may get investors as excited as if you were a director. The only problem with this is that the names of such advisors do not show up routinely on corporate filings and registries when investors are performing their analysis. They are definitely not committed to the company in the same way that directors are. From a prospective director’s perspective, why not start out as an advisor before committing to a board seat? And, don’t discount the consultancy idea, either.

If it is your reputation that is being sought – be cautious. The last thing you’d want is to tarnish a good reputation. This can easily happen through no fault of your own. A market down-turn or an ominous competitor could shake your company’s and your reputation! Again, if you want to help out but are risk-averse, consider an advisory or mentoring role.

Advisory Boards

In addition to a board of directors a company could establish one or more advisory boards. For example, a “scientific advisory board” would be useful in providing technical guidance to a firm whereas a “business advisory board” would be helpful in advising on matters of a financial or marketing nature. Be careful though – if an advisory board is seen to be making decisions, a judge in a court of law might view such a board as a de facto board of directors and may regard the “advisors” as directors, holding them liable for any damaging actions.

Often, chief executives of companies may be well served by a personal advisory group, such as a peer group of non-competing CEOs (an example of this is the TEC organization), to act as a sounding board since it is, after all, lonely at the top . I once belonged to a so-called executive development group comprised of ten other chief executives from very diverse industries (a dairy producer, an electronics manufacturer, a foundry operator, a printer, etc.) which met monthly, along with a “facilitator” to discuss topics ranging from nepotism to optimal corporate structures to minimize taxes.

Mentors

Every entrepreneur or manager should have a mentor. A mentor provides guidance and insight as well as serving as a role model. There are two types of mentors: real live hands-on people and those which may not be physically present. In the latter category, one might select persons held in particularly high regard and whose behavior one would like to emulate. The computer software CEO could ask himself, “Now, what would Bill Gates do in a situation like this?” or a CEO concerned about an employee issue, might ask himself, “How would Albert Schweitzer deal with this problem?” One really good aspect of such mentors is that you can choose several – one for leadership, one for spiritual matters, one for technical prowess, etc. And, you can “speak” to them frequently! The real live ones are not quite as accessible or as easy to engage. It is surprising, though, how keen many people are to serve in the mentorship role. It is a great way for successful individuals to feel good about themselves – i.e. helping someone else become successful.

Finding and Compensating Directors, Advisors and Mentors

Good directors, advisors, and mentors are out there. The trick is to identify the right ones for you and your business and to attract them. Introductions are a good way. Use your company’s professional consultants (lawyers, accountants, etc.) to introduce you to potential candidates. Attend networking social functions and mingle with strangers. Don’t be afraid to approach a higher profile person. Such an individual may be impressed, even flattered, with your moxie for just asking them. Read the local business papers to learn more about business leaders in your own community.

Once you have found people whose advice could be useful to you, how do you reward or compensate them for their time, interest, and expertise? After all, just a few words of common sense precipitated by decades of learning experiences, may be of immense value. Do you pay them a fee or compensate them with shares in your company? Even though they may be very gratuitous, it is a good idea to provide at least some, however modest, financial compensation. This establishes a fiduciary trust relationship. As for the amount, ask the person what he or she considers appropriate. If you feel like they are ripping you off, they probably are and you should think twice about the relationship. Certainly, a “piece of the action”, i.e. equity, or options on equity are attractive to such people. There are no well established rules of thumb governing such relationships and the best approach is to check around with others who have gone through this exercise. It is not unusual for the directors as a group to be given between 5% and 10% equity (or stock options) over a 3-5 year vesting period. Additionally, paying a retainer fee, however large or small, should be considered.

For a startup, giving a director a 2% share in the company is not unreasonable. Think of it this way – by the time the company is sold there will have been dilutive investment rounds and that 2% position is now likely less than 1%. Suppose that the company is sold in 5 years for $30 million. That would give the director a $300K payday. While that’s a nice payoff, it’s not overly generous considering that the odds of achieving this are less than 50%. On the other hand, it may just be attractive enough to get quality directors on board.

When entering into such advisory relationships, it is prudent to define the time commitments – both in terms of actual time which you think you require and which the advisor is prepared to give as well as the duration of the relationship. For example, can you count on a minimum of three hours per week for a weekly meeting over the next year? Also allow for a mutual escape clause – if this arrangement isn’t working out for both parties, it should be terminated. This doesn’t necessarily have to be formalized, but it must be understood. The time and attention that directors should commit to a company is never trivial. I often see fully employed executives serving on a dozen other boards. How can they possibly handle this?

The Bottom Line – for Directors

Just remember that, when you agree to serve as a director (should sign a consent form), you are on the hook. All corporate actions during the term of your tenure rest on your shoulders. Simply resigning will not get you off the hook. You will be held responsible (and liable) for matters such as Labor Board issues or taxes owing, which occurred at the time of your tenure! There is no way out. The buck stops – with you!

Summary

Here are some of the benefits as well as some of the risks and challenges associated with directorship – both from the company’s and the director’s perspective: